Lange Note-The New Antifraud Rule

Fordham Law Review
Volume 77 | Issue 2 Article 17
2008
The New Antifraud Rule: Is SEC Enforcement the
Most Effective Way to Protect Investors from
Hedge Fund Fraud?
Kathleen E. Lange
This Article is brought to you for free and open access by The Fordham Law School Institutional Repository. It has been accepted for inclusion in
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tmelnick@law.fordham.edu.
Recommended Citation
Kathleen E. Lange, The New Antifraud Rule: Is SEC Enforcement the Most Effective Way to Protect Investors from Hedge Fund Fraud?, 77
Fordham L. Rev. 851 (2008).
Available at: http://ir.lawnet.fordham.edu/flr/vol77/iss2/17

THE NEW ANTIFRAUD RULE:
IS SEC ENFORCEMENT THE MOST EFFECTIVE
WAY TO PROTECT INVESTORS FROM HEDGE
FUND FRAUD?
KathleenE. Lange*
Hedge funds have consistently grown in both size and influence.
Traditionally,hedge funds escaped regulation because access was limited
to the wealthy and sophisticated. However, due to inflation, the wealth
threshold has become more attainableto less sophisticatedinvestors. Also,
an increasing number of pension funds and other institutional investors
have begun to invest a significantportion of their money in hedge funds.
This increased growth, combined with the "retailization"of the industry,
has led to concern over whether investors are adequately protectedfrom
the correspondinggrowth in hedge fund fraud. This Note argues that,
absent new legislation, the SEC cannot effectively protect investors, but it
suggests that the creationof a self-regulatoryorganizationfor hedgefunds
mightprovidethe bestprotectionfor these investors.
INTRODUCTION
In 1996, Samuel Israel III and Daniel Marino started the Bayou Fund, a
"private pooled investment fund, known as a 'hedge fund."'" Within only a
few months, the fund sustained heavy trading losses.2 Israel and Marino
concealed these losses from Bayou's early investors by lying to them about
"the Fund's performance and the value of the investors' accounts." 3 In
* J.D. Candidate, 2009, Fordham University School of Law; B.A., 2005, Fairfield
University. I would like to thank Professor Sean Griffith for his invaluable guidance, my
family for their unwavering support, and Arnie Jacobs for being the best mentor for which an
aspiring lawyer could ask.
1. Complaint at 5, SEC v. Israel, No. 05 civ. 8376 (S.D.N.Y. Sept. 29, 2005)
[hereinafter Israel Complaint]. "The Bayou Fund apparently was conceived as a real hedge
fund that traded securities." Id.at 2. In January 2003, the Bayou Fund was reorganized and
liquidated to create four separate hedge funds: Bayou Accredited Fund, LLC; Bayou
Affiliates Fund, LLC; Bayou No Leverage Fund, LLC; and Bayou Superfund, LLC. Id. at 5.
2. Id.at 5.
3. Id. at 2 (alleging defendants "knowingly misrepresented the value and performance
of the Bayou Fund and the four successor Funds to clients; [and] issued false and misleading
financial statements, account statements and performance summary documents"); see also
Greg Farrell, Empty Promises in Hedge Fund Fraud: SEC Says Bayou's Executives
Deceived Investorsfrom Start, USA TODAY, Sept. 30, 2005, at B3 (reporting that Samuel
Israel and Daniel Marino "disguised trading losses from Bayou's early investors by lying

FORDHAMLAW REVIEW
*1998, the fund "sustained a net loss of millions of dollars from trading," and
by year end, Israel and Marino could no longer manipulate the fund's
records to conceal the mounting losses and withstand an independent audit.4
Instead of admitting their losses, Israel and Marino fired their independent
auditing firm, and Marino created "Richmond-Fairfield Associates," a
"fictitious accounting firm" that he used to produce fabricated "auditor's
reports, financial statements, and performance summaries."' 5 After
continued losses in 1999, Israel and Marino "again concealed the loss by
creating and distributing to the fund's investors false performance
summaries and a false financial statement that had purportedly been audited
by Richmond-Fairfield Associates." 6 According to the complaint filed by
the Securities and Exchange Commission (SEC), Bayou and its successor
funds received over $450 million from investors between Bayou's inception
in 1996 and July 31, 2005.7
Despite continued losses, Israel and Marino
continued to solicit capital from both new and current investors.8 In 2003
alone, Israel and Marino received more than $125 million from investors.9
Although Bayou never actually operated at a profit, Israel and Marino paid
themselves "incentive fees" based on fictionalized profits. 10
In April 2004, Israel and Marino suspended most trading, "drained
virtually all of the [flunds' prime brokerage accounts, and wired the
remaining funds, approximately $150 million, into Bayou Management's
account at Citibank."" With the remaining money, Israel continued to
"invest in a series ofprime bank instrument trading programs."' 2 In a letter
from Israel and Marino dated July 27, 2005, investors were informed that
the Bayou funds were voluntarily liquidating and that "ninety percent of the
clients' capital balances would be distributed by August 12, 2005, with the
remaining ten percent to follow at the end ofthe month." 13 In a subsequent
letter dated August 11, 2005, Israel promised clients that "they would
about the fund's performance and padding the results with infusions of cash from Bayou
Securities, a stock-trading subsidiary that racked up heavy commissions from Israel's
frenetic trading"). One example of their misrepresentations is documented in the funds'
2003 annual statement, in which the defendants reported "that Bayou Superfund had earned
more than $25 million." Israel Complaint, supra note 1, at 8. In reality, "Bayou Superfund
took in more than $90 million in investments [in 2003], but lost approximately $35 million
through trading." Id.
4. Israel Complaint, supranote 1,at 6.
5. Id. Marino was a certified public accountant. Id.
6. Id. at 7 ("In the summaries and year-end financial statements, Israel and Marino
again fabricated the [f]und's results in order to make it appear that the [f]und was earning
trading profits and achieving earnings targets that the defendants had formulated to create
the appearance of modest, steady, and believable growth.").
7. Id.at 5.
8. Id.at 7.
9. Id.
10. Id. at 8.
11. Id. at9.
12. Id. (internal quotation marks omitted). "Despite the patently dubious nature of the
trading programs to which he was being steered, Israel pursued them using monies taken
from the [flunds." Id.
13. Id. at 13.
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THE SEC'S NEWANTIFRA UDRULE
receive ninety percent of their investments the following week and the
remaining ten percent by the end of the month."'1 4 However, the
redemption checks sent to investors were returned for insufficient funds,
and most investors were unable to retrieve their money. 15
The story of the Bayou funds is just one of the many examples of how
investors are harmed by the fraud committed by hedge fund advisers.
Issues relating to the magnitude of these frauds and how best to protect
investors remain unsettled and controversial. One of the most significant
hurdles faced by these victims of fraud is producing sufficient evidence to
support their claims. The San Diego County Employees Retirement
Association (SDCERA) is currently grappling with this issue in its lawsuit
against Amaranth Advisers LLC.16
In 2005, SDCERA invested $175 million with Amaranth Advisers
LLC.17 Amaranth was a Greenwich, Connecticut-based hedge fund that
once managed over $9 billion in assets.18 SDCERA is currently in the
midst of litigation resulting from Amaranth's collapse after the hedge fund
sustained $6.6 billion in natural gas trading losses in September 2006.19
The complaint, filed by SDCERA in the U.S. District Court for the
Southern District of New York, accuses Amaranth of "defrauding clients by
misrepresenting itself as a fund that invested in many different assets."20
The complaint claims that "'[t]he fund, against its own espoused investment
policies, effectively operated as a single-strategy natural-gas fund that took
very large and highly leveraged gambles and recklessly failed to apply even
basic risk-management techniques and controls." 21
Although SDCERA hopes to prevail at trial, it faces a long process with a
heavy burden of proof.22 Nonetheless, the failure of the fund has left San
Diego County employees with "jitters and some panic." 23 According to
14. Id.
15. Id. ("Documents obtained from Bayou-related bank accounts show that the accounts
were overdrawn before the liquidation and redemption checks were drafted.").
16. See Complaint, San Diego County Employees Ret. Ass'n v. Maounis, No. 07 civ.
2618 (S.D.N.Y. Mar. 29, 2007) [hereinafter SDCERA Complaint].
17. Jenny Strasburg, Amaranth Sued by San Diego, Warns of Refund Delays,
BLOOMBERG, Mar. 30, 2007, http://www.bloomberg.com/apps/news?pid=20601087&sid=al
2cSn2AKd5Y&refer=home. New Jersey's pension fund, another Amaranth investor, may
"lose $16 million of its $25 million it [originally] invested with Amaranth." Amaranth Fund
Details Losses to Investors: Lost $6 billion, Had to Sell Assets to Cover Bad Natural Gas
Investments, MSNBC, Sept. 21, 2006, http://www.msnbc.msn.com/id/14927007/.
18. See Strasburg, supranote 17 ("Amaranth's assets peaked at $9.5 billion in August as
rising prices increased the value of its holdings.").
19. Id. The complaint seeks damages of at least $150 million based on the retirement
plan's initial investment. Id.
20. Id.
21. Id. (quoting SDCERA Complaint, supranote 16, at 2).
22. Id. ("Investors 'must show that the firm engaged in fraud and malfeasance, with
direct evidence establishing more than just that someone could have done a better job with a
risky investment."' (quoting Seth Berenzweig, a lawyer with Virginia-based Albo & Oblon
LLP)).
23. Josh Gerstein, Lawyers Circle After FailureofHedge Fund,N.Y. SuN, Oct. 20-22,
2006, at Al.
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FORDHAM LA W REVIE W
Dorothy Sloter, the head of SDCERA, the employees are "very
concerned.... about their retirement, and the security of their pensions. '24
The collapse of Bayou and Amaranth illustrate how fraud and
mismanagement of hedge funds can significantly harm investors. Cases
such as these have fueled discussions over the need for additional
regulatory oversight and protection for investors from fraud. Fraud is
defined as a "knowing misrepresentation of the truth or concealment of a
material fact."'25
Fraud is therefore an intentional deception, making it
inherently difficult to discover, even through regular SEC inspections. 26
Although the exact number of hedge funds is hard to quantify, it is clear
that hedge funds are continually growing in "size, scope and influence. ' 27
In 2006, the number of hedge funds grew by 10%, and there are currently
about 9000.28 Hedge funds are estimated to "account for 20% to 50% of
the daily trading volume on the New York Stock Exchange. '29
The "total
assets under management by hedge funds have reached approximately $2
trillion and assets under management are expected to grow at an annualized
rate of 15% between 2005 and 2008."30
Traditionally, investors in hedge funds were not thought to need the full
protections of federal securities laws and regulations. 3 1
Hedge funds were
considered "private and largely unregulated investment pools for the
rich."'32
However, over time, inflation has lowered the wealth threshold to
buy into these funds, making them more accessible to many unsophisticated
investors. Additionally, much of the growth of the hedge fund industry
24. Id.
25. BLACK'S LAW DICTIONARY 685 (8th ed. 2004).
26. See Role ofHedge Fundsin the CapitalMarkets: HearingBefore the Subcomm. on
Securities, Insurance, and Investment of the S. Comm. on Banking, Housing, and Urban
Affairs, 109th Cong. 4 (2006) [hereinafter Hedge Fund Hearing] (statement of Patrick M.
Parkinson, Deputy Director, Division of Research and Statistics, Board of Governors of the
Federal Reserve System). "For example, three Federal Reserve examinations of the New
York branch of Daiwa Bank between 1992 and 1994 failed to uncover $1.1 billion of hidden
trading losses." Id. at 4 n. 10.
27. Michael Pereira, Hedge Fund Taxation, METROPOLITAN CORP. COUNS., Sept. 2007,
at 13, availableathttp://www.metrocorpcounsel.com/pdf/2007/September/l 3.pdf.
28. Id. These figures were reported in September of 2007. Id.
29. Federal Bureau of Investigation, Hedge Fund Information for Investors,
www.fbi.gov/page2/marchO7/hedge-fund.htm (last visited Oct. 24, 2008).
30. Id.
31. See Goldstein v. SEC, 451 F.3d 873, 875 (D.C. Cir. 2006) ("Investment vehicles that
remain private and available only to highly sophisticated investors have historically been
understood not to present the same dangers to public markets as more widely available
investment companies, like mutual funds."); see also Federal Bureau of Investigation, supra
note 29 ("The theory behind their creation was that high-wealth investors are 'financially
sophisticated' and therefore did not need or want to incur the additional administrative
expense of reporting to a regulatory agency.").
32. ROGER LOWENSTEIN, WHEN GENIUS FAILED: THE RISE AND FALL OF LONG-TERM
CAPITAL MANAGEMENT 24 (2000).
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"can be attributed to the investments of institutional investors. '33 An
increasing number of institutional investors such as public and private
pension funds, university endowments, charitable organizations, and
foundations are investing a significant portion of their money in hedge
funds.34 Hedge funds have also become accessible to small investors who
are now able to invest through broker firms that package hedge funds into
"funds of hedge funds."'35
The growth in the number of hedge funds and the value of assets under
their management, combined with the "retailization" of the industry, has led
to concern over whether investors are adequately protected from the
corresponding growth in hedge fund fraud.36 In the past, the SEC was able
to use various securities laws to enforce fraud actions against hedge funds.
However, this enforcement power was questioned by the U.S. Court of
Appeals for the District of Columbia Circuit in Goldstein v. SEC.37
The
SEC responded to the resulting uncertainty by creating a new antifraud
provision aimed at prohibiting advisers to pooled investment vehicles from
defrauding investors in the investment vehicles they advise.38
Part I of this Note traces the history of hedge fund regulation and the
industry in general. Part II assesses the most recent SEC antifraud rule
relating to hedge funds. Part II also discusses alternatives to SEC
regulation proposed to protect investors from fraud within the hedge fund
industry. Part III argues that the current SEC rule will not effectively
protect investors or deter fraud within hedge funds. Part III then proposes
33. STAFF, SEC. & EXCH. COMM'N, IMPLICATIONS OF THE GROWTH OF HEDGE FUNDS 43
(2003), available at http://www.sec.gov/news/studies/hedgefunds09O3.pdf [hereinafter
STAFF REPORT ON THE GROWTH OF HEDGE FUNDS].
34. Investor Protection and the Regulation of the Hedge Funds Advisers: Hearing
Before the S. Comm. on Banking, Housing, and Urban Affairs, 108th Cong. 5-6 (2004)
(statement of William H. Donaldson, Chairman, U.S. Securities and Exchange Commission).
Best industry estimates indicate "that pensions' investments in hedge funds have increased
from $13 billion in 1997 to more than $72 billion so far in 2004, an increase of more than
450 percent." Id. at 6.
35. U.S. Securities and Exchange Commission, Hedging Your Bets: A Heads Up on
Hedge Funds and Funds of Hedge Funds, http://www.sec.gov/answers/hedge.htm (last
visited Oct. 24, 2008). "A fund of hedge funds is an investment company that invests in
hedge funds-rather than investing in individual securities." Id. "Many registered funds of
hedge funds have much lower investment minimums (e.g., $25,000) than individual hedge
funds. Thus, some investors that would be unable to invest in a hedge fund directly may be
able to purchase shares ofregistered funds of hedge funds." Id.
36. Investor Protection and the Regulation of the Hedge Funds Advisers: Hearing
Before the S. Comm. on Banking, Housing, and Urban Affairs, 108th Cong. 8-9 (2004)
(testimony of William H. Donaldson, Chairman, U.S. Securities and Exchange
Commission). The "retailization" of hedge funds refers to "the increasing ability of less
qualified (or retail) investors to access hedge fund investments." Franklin R. Edwards,
Hedge Funds and Investor Protection Regulation 15-16 (May 16, 2006) (unpublished
conference paper), available at http://www.frbatlanta.org/news/conferen/06fmc/06fmc-
edwards.pdf.
37. Goldstein v. SEC, 451 F.3d 873, 874-77 (D.C. Cir. 2006); see infra Part I.C.1.
38. 17 C.F.R. § 275.206(4)-8 (2008); Prohibition of Fraud by Advisers to Certain Pooled
Investment Vehicles, Investment Advisers Act Release No. IA-2628, 72 Fed. Reg. 44,756,
44,756 (Aug. 9, 2007) [hereinafter SEC Release: Antifraud Rule].
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that investors will be better protected by creating a self-regulatory
organization for hedge funds.
I. HEDGE FUNDS AND THE SEC
This part explores the history of hedge funds and their rapid growth that
attracted increased attention regarding the role of the SEC in protecting
hedge fund investors from fraud committed by their advisers. Part I.A
defines hedge funds and details how they have historically escaped
regulation under the federal securities laws. Part II.B explains how the
expansion of the hedge fund industry and the near-collapse of Long-Term
Capital Management led the SEC to investigate and enact a new "hedge
fund rule" requiring hedge fund advisers to register with the Commission.
Part I.C discusses the D.C. Circuit Court's decision to vacate this rule and
how the SEC responded by enacting a new antifraud provision to protect
investors in hedge funds from fraud. Finally, Part I.D discusses
government and industry responses to these events and the role of self-
regulatory organizations within the federal securities laws.
A. HedgeFundHistoryandRegulation
In the early 1990s, more Americans owned investments than ever before,
and stock prices were "rising to astonishing heights."39 As a result, "no
fewer than 6 million people around the world counted themselves as dollar
millionaires, with a total of $17 trillion in assets."40 With this increased
number of wealthy investors came an increased interest in investing in
hedge funds. Part I.A. 1 discusses the nature of hedge funds while Part
I.A.2 discusses how hedge funds have dodged regulation by the
Commission under the federal securities laws.
1. Defining "Hedge Funds"
Hedge funds are "notoriously difficult to define." 41 The term "hedge
fund" is not mentioned anywhere in the federal securities laws, and even
within the industry, there is no single, agreed upon definition.42 The term is
commonly used as a catchall to encompass "any pooled investment vehicle
that is privately organized, administered by professional investment
39. LOWENSTEIN, supranote 32, at 23.
40. Id. (citing Franklin R. Edwards, Hedge Funds and the Collapse of Long-Term
CapitalManagement,J. ECON. PERSP., Spring 1999, at 189, 193).
41. Goldstein,451 F.3d at 874.
42. Id. at 874-75; see also STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supranote
33, at viii ("The term generally identifies an entity that holds a pool of securities and perhaps
other assets that does not register its securities offerings under the Securities Act and which
is not registered as an investment company under the Investment Company Act."); David A.
Vaughn, Dechert LLP, Comments for the U.S. Securities and Exchange Commission
Roundtable on Hedge Funds (May 13, 2003), http://www.sec.gov/spotlight/hedgefunds/
hedge-vaughn.htm (providing fourteen different definitions found in government and
industry publications).
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managers, and not widely available to the public."43 Hedge funds generally
pool capital from investors and invest those funds in securities and other
financial instruments in an effort to "limit risk and volatility while
providing positive returns under all market conditions." 44
a. StructureofHedgeFunds.
Most hedge funds are structured as limited partnerships to benefit
investors who are subject to U.S. taxation.45 They may also be organized as
limited liability companies or business trusts.46 A hedge fund organized as
a limited partnership has a general partner (also commonly referred to as the
fund manager or fund adviser), often itself a limited liability company or
other entity, which manages the fund (or several funds) and numerous
limited partners who are relatively passive investors.47 The fund manager
is given "broad investment discretion in selecting investments and trading
for the fund."'48 The day-to-day operations of the partnership are usually
governed by an Agreement of Limited Partnership.49
As discussed below, hedge funds do not typically offer securities to the
public. Instead, "[h]edge funds distribute securities in private offerings,
traditionally 'marketing' their interests through word of mouth and the
personal relationships with the hedge fund's advisory personnel."50
43. Goldstein, 451 F.3d at 875 (quoting PRESIDENT'S WORKING GROUP ON FIN. MKTS.,
HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT 1
(1999) [hereinafter LESSONS OF LTCM], available at http://www.ustreas.gov/press/releases/
reports/hedgfund.pdf).
44. THOMAS P. LEMKE ET AL., HEDGE FUNDS AND OTHER PRIVATE FUNDS: REGULATION
AND COMPLIANCE § 1.1, at 1-2 (2004-2005 ed. 2004).
45. Id. § 2.8, at 14.
46. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supranote 33, at 9 n.27. Each of
these formations are beneficial to the investors because they "are generally not separately
taxed and, as a result, income is taxed only at the level of the individual investor." Id. Other
benefits of these forms of organization include limiting the liability of an investor to the
extent of its investment in the fund and providing the general partner with broad authority
with respect to management. Id.
47. LEMKE ET AL., supra note 44, § 2.8, at 14. The general partner is responsible for the
general management of the fund, which includes selection of which investments to add to the
fund's portfolio, management of the assets and a number of other activities for the fund. Id. §
2.2, at 10. With the exception of the general partner, all investors are limited partners, who
"share in the partnership's income, expenses, gains and losses based on the balances in their
respective capital accounts, but do not exercise any day-to-day management or control over
the partnership." Id. § 2.8, at 14.
48. Id. § 2.2, at 10.
49. Id. § 2.8, at 15. The Agreement of Limited Partnership usually sets forth important
aspects of operating the fund, including, but not limited to, who is responsible for managing
the fund, the powers of the general partner, the object or purpose of the partnership,
indemnification, the management fees and performance allocations and valuation of
portfolio assets. Id. § 2.8, at 15-16.
50. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supranote 33, at ix.
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b. Compensation
One common characteristic among hedge funds is their fee structure.
Fund advisers or managers are typically compensated with a base
management fee (usually a percentage, commonly one to two percent, of
the fund's assets).51 In addition to this base fee, there is typically a
performance component to their compensation, which is usually a
percentage of the increase in the fund's value (e.g., twenty percent of
positive return).52 Managers commonly make significant direct investments
in the funds they manage. 53 The performance component of a manger's
compensation, along with their personal investment, tends to create a strong
alignment of interests between the outside investors in the hedge fund and
the manager.54
c. Relationshipswith Investors andDisclosure
Hedge funds are generally not required to make extensive disclosures to
investors or regulators. 55 Therefore, "limits or restrictions on hedge funds'
activities are determined not by regulation but primarily by the contractual
relationships they have with their investors and by market discipline exerted
by the creditors, counterparties, and investors with whom they transact." 56
Investors typically receive information from hedge fund advisers "during an
investor's initial due diligence review of the fund, although some, more
proprietary information may not be provided until after the investor has
made a capital commitment to the fund, if at all."'57
The relationship between the fund manager and the investors is usually
governed by an Agreement of Limited Partnership. 58 Although hedge funds
typically are not legally required to provide disclosure to investors, many
"unregistered and unregulated hedge funds make some disclosures in the
form of private placement memorand[a], conference calls, informal
conversations, and other unofficial devices." 59 In addition, some hedge
funds use other legal documents to cover the relationship between investors
51. LEMKE ET AL., supranote 44, § 1.1, at 2; STAFF REPORT ON THE GROWTH OF HEDGE
FUNDS, supranote 33, at ix.
52. LEMKE ET AL., supranote 44, § 1.1, at 2.
53. MANAGED FUNDS ASSN, SOUND PRACTICES FOR HEDGE FUND MANAGERS intro., at 8
(2007) [hereinafter SOUND PRACTICES], available at http://www.managedfunds.org/
downloads/Sound%20Practices%202007.pdf. This investment approach "can be particularly
important in attracting outside investors since it aligns the fund manager's interests with
those of outside investors and exposes the fund manager to the same investment risks."
LEMKE ET AL., supranote 44, § 1.1, at 2.
54. SOUND PRACTICES, supranote 53, intro., at 8.
55. Edwards, supranote 36, at 10.
56. Id.
57. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supranote 33, at 46.
58. SOUND PRACTICES, supra note 53, intro., at 9.
59. Daniel K. Liffmann, Registration of Hedge Fund Advisers Under the Investment
Advisers Act, 38 LOY. L.A. L. REv. 2147, 2159 (2005).
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and managers, including offering memoranda, subscription agreements, or
similar contracts. 60
Given the structure of most hedge funds, it is generally understood that
the client of the manager is the hedge fund itself-not the individual
investors.61 Even though the manager may, and often does, interact with
the investors, the manager is viewed as providing "its investment advice to
the Hedge Fund in accordance with the investment strategy and objectives
set forth in the Hedge Fund's offering documents, rather than any specific
objectives or directives ofany individual Hedge Fund investor. '62
In order to invest in a hedge fund, investors are required to meet certain
standards, such as net worth or other financial sophistication
requirements. 63 U.S. securities laws require that hedge fund investors,
whether institutional or individual, satisfy the specified eligibility
requirements based on their wealth and sophistication because investment
in the funds is not available to the public.64 In addition to these restrictions,
"managers of certain institutional investors, such as pension fund plans, are
fiduciaries with a legal duty to act in the best interest of plan beneficiaries
when making any investments on behalf of the institution. '65
d. Investment GoalsandStrategies
In the current financial market, the term "hedge fund" has been
understood to describe a "wide range of investment vehicles that can vary
substantially in terms of size, strategy, business model, and organizational
structure." 66 The first hedge funds "invested in equities and used leverage
and short selling to 'hedge' the portfolio's exposure to movements of the
corporate equity markets." 67 However, since hedge funds are not generally
restrained or restricted by diversification requirements, they began to
diversify their investment portfolios and engage in a wider variety of
investment strategies. 68 Hedge funds today trade not only equities, but also
"fixed income securities, convertible securities, currencies, exchange-traded
futures, over-the-counter derivatives, futures contracts, commodity options
61. Id. intro., at 8. Although a manager's client is considered the hedge fund itself, the
manager often communicates with the investors about matters related to the fund, including
"its investment objectives, strategies, terms, and conditions of an investment in the hedge
fund." Id. intro., at 9.
62. Id. intro., at 8.
63. Id. intro., at 9; seeinfra Part I.A.2.
65. Id.
66. Id. intro., at 7.
67. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 3 (discussing
Alfred Winslow Jones, who "is credited with establishing one of the first hedge funds as a
private partnership in 1949"). Hedge funds "may obtain leverage by purchasing securities
on margin, selling short, obtaining funding from banks or other sources, engaging in
repurchase agreements, or using various derivative or synthetic instruments." LEMKE ETAL.,
supranote 44, § 1.1, at 1-2.
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FORDHAMLAW REVIEW
and other non-securities investments." 69 Also, hedge funds today are not
tied to utilizing the hedging and arbitrage strategies that hedge funds
historically employed, and now many engage in relatively traditional long-
only equity strategies. 70
Hedge funds seek to achieve positive, absolute investment returns under
all market conditions, often with less volatility and risk than traditional
asset classes such as stocks and bonds.7' The funds typically engage in
many different investment strategies to achieve their investment goals,
including investment in "distressed securities, illiquid securities, securities
of companies in emerging markets and derivatives, as well as pursue
arbitrage opportunities, such as those arising from possible mergers or
acquisitions." 72 Managers of hedge funds are known to "employ more
complicated, flexible investment strategies than advisers at mutual funds
[and] brokerage firms." 73
e. Benefits ofHedgeFunds
Hedge funds in many respects tend to foster financial stability and
provide benefits to financial markets.74 Some of the important benefits that
hedge funds offer to capital markets include "'liquidity, price efficiency and
risk distribution.' 75 For example, "many hedge funds take speculative,
value-driven trading positions based on extensive research about the value
of a security." Funds that take such positions can enhance liquidity and
contribute to market efficiency. 76 Also, "hedge funds offer investors an
important risk management tool by providing valuable portfolio
diversification because hedge fund returns in many cases are not correlated
to the broader debt and equity markets." 77 However, there are increasing
concerns expressed by policy makers with respect to certain activities of
hedge funds and the potential for systematic risk. In particular, regulatory
supervisors have taken interest in over-the-counter derivatives, expressing
69. Id.
70. Id. at 3-4. Long-only investment strategy is when a fund "purchases and sells
securities, but does not sell securities short to a significant extent." LEMKE ET AL., supranote
44, § 1.2, at 2.
71. See LEMKE ET AL., supra note 44, § 1.1, at 1-2; STAFF REPORT ON THE GROWTH OF
HEDGE FUNDS, supranote 33, at 4.
73. Id.
74. Hedge Funds andSystemic Risk: Perspectivesof the President'sWorking Group on
FinancialMarkets: Hearing Before the H. Comm. on Financial Servs., 110th Cong. 5
(2007) (statement of Kevin Warsh, Member, Board of Governors of the Federal Reserve
System); STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supranote 33, at 4.
75. Comment Letter from John G. Gaine, President, Managed Funds Ass'n, to Nancy M.
Morris, Sec'y, U.S. Sec. & Exch. Comm'n 2 (Mar. 9, 2007) [hereinafter MFA Letter],
availableat http://www.sec.gov/comments/s7-25-06/s72506-567.pdf (quoting Regulation of
Hedge Funds: Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs,
109th Cong. 2 (2006) (statement of Randal K. Quarles, Under Secretary for Domestic
Finance, U.S. Department of the Treasury)).
76. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supranote 33, at viii.
77. Id.
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THE SEC'SNEWANTIFRA UD RULE
their "concern that a major credit event could have a substantial impact on
global financial markets."78
2. The Regulation of Hedge Funds and Their Advisers
In the United States, hedge funds are neither authorized nor restricted by
the government; nor does the government mandate that hedge funds and
their advisers make specific disclosures to investors.79 The United States
does not have a strict comprehensive system to regulate hedge funds;
instead, "[i]n the United States the regulation of hedge funds might be best
characterized as a patchwork of exemptions from various investor-
protection laws."' 80 Hedge funds are investment pools with substantial
investments in securities, whose activities could potentially subject them to
legal restrictions and regulations. Therefore, most funds operate themselves
in such a manner that exempts them from regulation under the four major
U.S. securities laws that could potentially affect them-the Securities Act
of 1933 (Securities Act),8' the Securities Exchange Act of 1934 (Exchange
Act), 82 the Investment Company Act of 1940 (Company Act),83 and the
Investment Advisers Act of 1940 (Advisers Act).84 Hedge funds escape
registration under these Acts through certain exclusions or exemptions,
which include limiting availability only to certain sophisticated or
accredited investors and not offering or selling interest or shares to the
general public. 85
The Company Act restricts registered investment companies to the types
of transactions they may undertake. 86 The Act charges the Commission
with regulation of any issuer of securities that "is or holds itself out as being
engaged primarily ...in the business of investing, reinvesting, or trading in
securities." 87 Since most hedge funds have substantial investments in
securities, they fall within the definition of an investment company under
the Act. However, most hedge funds avoid regulation by fitting into one of
78. SOUND PRACTICES, supranote 53, intro., at 4-5.
79. Edwards, supranote 36, at 7.
80. Id.
81. 15 U.S.C. §§ 77a-77aa (2006). The Securities Act seeks to "provide full and fair
disclosure in securities transactions." STAFF REPORT ON THE GROWTH OF HEDGE FUNDS,
supranote 33, at 13. The Act generally "requires issuers to register a security with the SEC
before it is offered to the public." Jennifer Ralph Oppold, The ChangingLandscape of
Hedge FundRegulation: CurrentConcerns and a Principle-BasedApproach, 10 U. PA. J.
Bus. & EMP. L. 833, 843 (2008). Hedge funds typically escape regulation under the
Securities Act by obtaining their "investors through private placements rather than a public
offering," which requires that they meet "the requirements of section 4(2) or Regulation D"
of the Securities Act, and "usually means restricting their investors to 'accredited'
investors." Edwards, supranote 36, at 8.
82. 15 U.S.C. §§ 78a-78111. For a discussion of the Exchange Act and how it regulates
hedge funds, see Oppold, supra note 81, at 845-46.
83. 15 U.S.C. §§ 80a-1 to -64.
84. Id. §§ 80b-I to-21.
85. LEMKE ET AL., supranote 44, § 1.1, at 1-2.
86. Id.
87. 15 U.S.C. § 80a-3(a)(1)(A).
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FORDHAMLAW REVIEW
two statutory exclusions to the definition of an investment company. 88
Section 3(c)(1) excludes an entity from the definition if the outstanding
securities are "beneficially owned by not more than 100 persons" and if the
entity does not presently or in the future plan to offer its securities to the
public.89 The second provision that hedge funds typically rely on is section
3(c)(7). Under this section, a fund is not considered an investment
company if outstanding securities are owned exclusively by "qualified
purchasers" and its securities are not offered to the public.90
Since most hedge funds are not regulated by the Company Act, they have
greater flexibility in their investment strategies than the investment vehicles
defined as investment companies, such as mutual funds.91 Because of their
exemption, hedge funds can remain secretive about their positions and
strategies, while mutual funds are required to "disclose their investment
positions and financial condition."92 Also, mutual funds and other
registered investment companies face significant restrictions on permissible
transactions. 93 Freedom from these constraints allows hedge funds to trade
in a much greater variety of assets, "from traditional stocks, bonds, and
currencies to more exotic financial derivatives and even non-financial
assets."
94
The Advisers Act is mainly a registration and antifraud statute that
regulates most investment advisers by imposing registration and disclosure
88. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 11. Sections 3
and 4 of the Securities Act exempt certain securities and transactions from the registration
requirements. ARNOLD S. JACOBS, 5 DISCLOSURE AND REMEDIES UNDER THE SECURITIES LAW
§ 3.3 n.3 (2008). Section 3(a) exempts specific securities. Id. "In addition to the exemptions
provided by statute under Section 3(a), Sections 3(b) and 3(c) permit the SEC to promulgate
rules and regulations adding other exempt classes of securities." Id.
89. 15 U.S.C. § 80a-3(c)(1). Funds that rely on section 3(c)(1) must "comply with
Section 4(2) of the Securities Act, and frequently do so by relying on the safe harbor
available under Regulation D under that Act." STAFF REPORT ON THE GROWTH OF HEDGE
FUNDS, supranote 33, at 12. Reliance on Regulation D requires that hedge funds "offer their
securities only to 'accredited investors,' and [that they] not engage in any general solicitation
or general advertising of their shares." Id. Accredited investors include "individuals with a
minimum annual income of $200,000 ($300,000 with spouse) or $1 million in net worth and
most institutions with $5 million in assets." Id.
90. 15 U.S.C. § 80a-3(c)(7)(A). Under section 2(a)(51) of the Company Act, a
"qualified purchaser" means "any natural person ... who owns not less than $5,000,000 in
investments" or "any person, acting for its own account or the accounts of other qualified
purchasers, who in the aggregate owns and invests on a discretionary basis, not less than
$25,000,000 in investments." Id. § 80a-2(a)(5 l)(i), (iv).
91. Federal Bureau of Investigation, supra note 29 ("Hedge funds can invest in equities,
bonds, options, futures, commodities, arbitrage and derivative contracts, as well as illiquid
investments such as real estate.").
92. Goldstein v. SEC, 451 F.3d 873, 875 (D.C. Cir. 2006).
93. Id. For example, registered investment companies are "foreclosed from trading on
margin or engaging in short sales and must secure shareholder approval to take on significant
debt or invest in certain types of assets, such as real estate or commodities." Id. (citing 15
U.S.C. §§ 80a- I2(a)(1), (a)(3), 80a- 13(a)(2)).
94. Id. at 876.
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THE SEC'S NEWANTIFRAUD RULE
requirements, as well as substantive regulatory requirements on them.95
Hedge fund advisers generally satisfy the definition of an "investment
adviser" under the Advisers Act.96 However, advisers to hedge funds may
avoid registering with the Commission if they satisfy the elements of the
exemption under section 203(b) of the Act. An adviser may rely on the
"private adviser exemption" of section 203(b)(3) if the following conditions
are met: (1) the investment adviser has had "fewer than fifteen clients" in
the preceding twelve months; (2) the adviser does not hold "himself out
generally to the public as an investment adviser"; and (3) the adviser does
not act "as an investment adviser to any investment company registered
under [the Company Act]."'97 Although many hedge funds are not
registered under the Company Act, and their managers are exempt from
registration under the Advisers Act, they are still subject to the antifraud
provisions of the federal securities laws.98
For the purposes of section 203(b), the Commission rules provided that a
"legal organization," such as a hedge fund, would be counted as a single
"client." 99
Since even the largest hedge fund managers do not run fifteen
hedge funds, this provision provides an exemption for most hedge fund
managers. 100
95. LEMKE ET AL., supranote 44, § 3.1, at 25; see alsoRegistration Under the Advisers
Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. IA-2333, 69
Fed. Reg. 72,054, 72,054 (Dec. 10, 2004) [hereinafter SEC Release: Hedge Fund Rule]
("The Act contains a few basic requirements, such as registration with the Commission,
maintenance of certain business records, and delivery to clients of a disclosure statement
('brochure').").
96. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 20. Section
202(a)(1 1) of the Advisers Act generally defines an "investment adviser" as one who "for
compensation, engages in the business of advising others, either directly or through
publications or writings, as to the value of securities or as to the advisability of investing in,
purchasing, or selling securities." 15 U.S.C. § 80b-2(a)(1 1).
97. 15 U.S.C. § 80b-3(b)(3).
98. SEC Release: Hedge Fund Rule, supranote 95, at 72,054. Although advisers who
take advantage of the "private adviser exemption" must comply with the Act's antifraud
provisions, they "do not file registration forms with [the SEC] identifying who they are, do
not have to maintain business records in accordance with [SEC] rules, do not have to adopt
or implement compliance programs or codes of ethics, and are not subject to Commission
oversight." Id. These exempt advisers "are also subject to antifraud provisions of other
federal securities laws, including rule 1Ob-5" under the Exchange Act. Id. at 72,054 n.6.
99. Id. at 72,055 n.10. "Rule 203(b)(3)-1 under the Advisers Act provides that an
adviser may count a legal organization as a single client if the legal organization receives
investment advice based on its investment objectives rather than on the individual
investment objectives of its owners." STAFF REPORT ON THE GROWTH OF HEDGE FUNDS,
supra note 33, at 21 n.72.
100. Goldstein v. SEC, 451 F.3d 873, 876 (D.C. Cir. 2006). Some hedge fund managers
do register as an investment adviser because they do not meet the requirements of section
203(b), or they register "voluntarily because their investors demand it or for competitive
reasons." STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supranote 33, at 22.
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B. Long-Term Capitalandthe SEC's Response
This section discusses the SEC's growing interest and concern that led to
its attempt to increase regulation of hedge funds. Part I.B. 1 discusses the
near failure of Long-Term Capital Management (LTCM) and how this
event prompted the SEC to commence an investigation into the hedge fund
industry. Part I.B.2 summarizes the relevant findings reported by the SEC's
staff that led the Commission to adopt a new rule aimed at regulating hedge
funds. Part I.B.3 then sets forth the SEC's "Hedge Fund Rule" and how the
Commission believed this would help deter or detect fraud committed by
unregistered hedge fund advisers.
1. The Near Failure of LTCM
LTCM was a Greenwich, Connecticut-based fund that, at its peak, held
over $125 billion in assets under management. 10
LTCM was a bond-
trading firm run by John W. Meriwether, a former well-known trader at
Salomon Brothers, and comprised of "a group of brainy, Ph.D.-certified
arbitrageurs," many of whom were professors and two of whom had won
the Nobel Prize. 102
Due to Meriwether's popularity among the bankers, he
was able to obtain financing from every major Wall Street bank on highly
generous terms.10 3
LTCM became the envy of Wall Street. For over four
years, "[t]he fund had racked up returns of more than 40 percent a year,
with no losing stretches, no volatility, seemingly no risk at all."' 1 4
It
seemed that this incredibly smart group of men had "been able to reduce an
uncertain world to rigorous, cold-blooded odds."'10 5
In mid-August of 1998, Russia defaulted on its ruble debt which caused
the global bond markets to be highly unsettled. 10 6
This left LTCM on the
brink of failure. However, in addition to its bond trading, LTCM had
entered into thousands of derivative contracts that had intertwined the fund
with every bank on Wall Street, and "[a]lmost all of the country's major
financial institutions were put at risk due to their credit exposure to Long-
Term."'1 7
William J. McDonough, the president of the Federal Reserve
Bank of New York, feared that, if LTCM failed, "the markets would stop
working; that trading would cease; that the system itself would come
101. Goldstein, 451 F.3d at 877. For a complete account of the story of Long-Term
Capital Management (LTCM), see LOWENSTEIN, supra note 32.
102. LOWENSTEIN, supra note 32, at xix.
103. Id. LTCM had amassed $100 billion in assets, virtually all of it borrowed from the
major Wall Street banks. Id. The fund had also "entered into thousands of derivative
contracts, which had endlessly intertwined it with every bank on Wall Street." Id. These
derivative contracts were essentially side bets on market prices and they created more than
$1trillion worth of exposure. Id. IfLTCM defaulted on these contracts, these banks "would
be exposed to tremendous-and untenable-risks." Id.
104. Id.
105. Id.
106. Id. at xx.
107. Goldstein v.SEC, 451 F.3d 873, 877 (D.C. Cir. 2006).
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THE SEC'S NEWANTIFRA UD RULE
crashing down."10 8 McDonough personally intervened by summoning the
heads of every major Wall Street bank to engineer a bailout of the fund and
avoid a national financial crisis.'0 9 Although the Commission had
previously been interested in regulating hedge funds, the failure of LTCM
led the Commission to explore ways to increase the regulation of hedge
funds. I10
2. The SEC Investigation ofHedge Funds
Beginning in June 2002, the SEC Staff of the Commission's Division of
Investment Management and Office of Compliance Inspections and
Examinations conducted a study aimed at reviewing the operations and
practices of hedge funds."' When the study was complete, the
Commission held a two-day roundtable on the hedge fund industry.112
After the Hedge Fund Roundtable, Chairman William H. Donaldson asked
the staff to compile a summary report (Staff Report) of its findings and
recommendations. 113 Based on the investigation and report, the
Commission decided that a new rule was necessary to detect fraud in hedge
funds in its early stages. 114
The study was largely the result of concern over the lack of information
available to the Commission "about hedge fund advisers that are not
registered under the Advisers Act and the hedge funds that they
manage.""15 Since hedge funds are generally not registered with the SEC,
"they are not subject to any reporting or standardized disclosure
requirements, nor are they subject to Commission examination." 116 The
Staff Report concluded that SEC efforts to detect hedge fund fraud at early
stages were unsuccessful due to an inability to obtain information. 117
As previously mentioned, even hedge funds that are not registered under
the Company Act and their advisers who are not registered under the
Advisers Act are subject to the antifraud provisions of the federal securities
laws. 118 At the time of the investigation, the Commission had brought
approximately thirty-eight enforcement actions since 1999 involving hedge
108. LOWENSTEIN, supranote 32, at xix-xx.
109. Id. at xviii.
110. Id.
111. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 2.
112. Id. at vii.
113. Id. at vii-viii.
114. See id.at x.
115. Id.
116. Id.
117. Id. This Note focuses only on the fraud aspects of the Staff Report, but the report
also addresses concern over the increasing participation of hedge funds in financial markets,
whether they are a danger to the stability of the U.S. financial markets and whether they
subject investors to inordinately high levels ofrisk.
118. Id.
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FORDHAMLA W REVIEW
fund fraud-fraud that resulted in significant losses to investors.1 19 Also at
the time of the Staff Report, the Commission was seeing a steady increase
in the number of fraud enforcement actions; however, it found that "[t]here
was no evidence indicating that hedge funds or their advisers engage
disproportionately in fraudulent activity."' 20
The investigation found that the fraud charges previously brought by the
Commission against hedge fund advisers were "similar to the types of fraud
charged against other types of investment advisers."' 21 These include:
"misappropriation of assets; misrepresentation of portfolio performance;
falsification of experience, credentials and past retums; misleading
disclosure regarding claimed trading strategies; and improper valuation of
assets."122 It found that "[t]he overwhelming majority of the cases the
Commission has instituted involve charges under.., the Securities Act, the
Exchange Act and the Investment Advisers Act." 123
The report provided four observations with regard to the hedge fund
enforcement actions brought by the Commission since 1999. First, it noted
that "[n]early a third of the hedge fund cases brought in the last four years
involved criminal charges."'124 Also, the staff noted that one characteristic
that seems common to hedge fund cases is how far violators will go to
conceal their fraud.' 25 The staff found that "[i]n almost half of the
enforcement actions brought since 1999, the defendants or respondents
created false documentation in an effort to hide their fraud."'1 26 Another
characteristic "that is perhaps more common to hedge fund cases than the
typical investment adviser's case is the greater frequency of outright theft,
or misappropriation, of investor funds." 127 Lastly, the staff reported that
"both registered and unregistered investment advisers have engaged in
hedge fund fraud."' 28
Typically the Commission identifies frauds and other misconduct
involving hedge funds only after they are contacted by "fund investors or
service providers [who] suspect fraudulent activity."'129 This translates to
119. Id. at 73. "In most cases involving hedge funds, the Commission institutes
enforcement actions against the hedge fund adviser and/or the adviser's principals." Id. at 73
n.252.
120. Id. at 73. The staff listed several factors that may be linked to the increase in the
number of hedge fund fraud cases, including "the popularity of hedge fund investments and
the large amounts of money they involve (and thus their attractiveness to perpetrators of
fraud); the entrance to the industry of inexperienced, untested and, in some cases,
unqualified individuals; and lack of adequate controls on the operations of some hedge fund
advisers." Id.
121. Id.
122. Id. at 73-74 (footnotes omitted).
123. Id. at 74.
124. Id.
125. Id.
126. Id. ("These documents included account statements and other types of reports to
customers, confirmations and pricing sheets.").
127. Id.
128. Id.
129. Id. at 76.
[Vol. 77

the Commission "instituting enforcement action against an unregistered
hedge fund adviser only after significant losses have occurred."'130 In
contrast, the Staff Report found that "the Commission has an advantage in
identifying the misconduct of registered investment advisers because they
are subject to periodic examinations by Commission staff."'131 Therefore,
the report suggested that when registered investment advisers partake in
fraudulent or other unlawful activity, their examinations could lead to
earlier discovery that could potentially prevent significant losses.132 Also,
they suggested that the Commission's "potential for a surprise examination
and deficiency letters to encourage a culture of compliance at regulated
entities" would serve to deter fraud and other misconduct. 133
3. The Hedge Fund Rule
After completing its study of the hedge fund industry in 2003, the SEC
issued a new rule over the dissent of two of the five SEC commissioners in
December 2004.134 Rule 203(b)(3)-2 (the Hedge Fund Rule) required that
investment advisers "count each owner of a 'private fund"' as a client,
which included "each shareholder, limited partner, member, or beneficiary
of the 'private fund.""' 135 Therefore, it required fund advisers to register
under the Advisers Act so that the Commission could gather "'basic
information about hedge fund advisers and the hedge fund industry,"'
"'oversee hedge fund advisers," and "deter or detect fraud by unregistered
hedge fund advisers.""' 136 The rule sought "to increase disclosure in an
industry with little transparency and to oversee an allegedly growing pool
ofassets."
137
130. Id.
131. Id. Although the Staff Report indicated that registration provides the SEC with an
advantage, others argue that there is no evidence that periodic examinations of registered
companies aid in preventing fraud. See, e.g., Hedge Fund Hearing, supra note 26; Jenny
Anderson, A Modest Proposalto Prevent Hedge FundFraud,N.Y. TIMES, Oct. 7, 2005, at
C6 ("The commission is not adequately staffed or technologically equipped to effectively
regulate the markets today. Adding 5,000 hedge funds to its to-do list is a dangerous
undertaking. While it is desirable to have a watchdog, there is no way the staff of the S.E.C.
can do it well .... ). When expressing his opposition to hedge fund regulation,
Commissioner Paul S. Atkins argued that "the commission did not have the resources to
police the mutual fund industry-one chock-full of small investors-so taking on the hedge
fund industry was an exercise in futility." Anderson, supra.
133. Id. at 76-77.
134. SEC Release: Hedge Fund Rule, supra note 95, at 72,087; see also Goldstein v.
SEC, 451 F.3d 873, 877 (D.C. Cir. 2006).
135. 17 C.F.R. § 275.203(b)(3)-2(a) (2008); SEC Release: Hedge Fund Rule, supranote
95, at 72,070.
136. Goldstein, 451 F.3d at 877 (quoting SEC Release: Hedge Fund Rule, supranote 95,
at 72,059).
137. Jessica Natali, Note, Trimming the Hedgesis aDifficult Task: The SEC's Attempt to
Regulate Hedge Funds Falls Short of Expectations, 15 U. MIAMI Bus. L. REv. 113, 115
(2006).
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FORDHAMLA W REVIEW
The Commission believed that, if it were able to continuously monitor
and examine the practices of hedge fund advisers, it would be able to
"effectively detect fraud and misconduct at much earlier stages, deter
fraudulent activities, better protect the investing public, and increase the
quality and fairness of hedge fund price valuation."'138 The Commission
stated in the release of the final rule that the "rule and rule amendments are
designed to provide the protections afforded by the Advisers Act to
investors in hedge funds, and to enhance the Commission's ability to
protect our nation's securities markets." 139
Under the Hedge Fund Rule, previously exempt advisers to hedge funds
now had to register with the Commission if they had fifteen or more
"clients." The rule defines a "private fund" as
an investment company that (a) is exempt from registration under the
Investment Company Act by virtue of having fewer than one hundred
investors or only qualified investors; (b) permits its investors to redeem
their interests within two years of investing; and (c) markets itself on the
basis ofthe 'skills, ability or expertise of the investment adviser.' 140
Due to the new definition of "private funds," and the specifications with
regard to who must be counted as a "client," most hedge fund managers
were required to register. 141 The rule mandated that these advisers, now
required to register under the new rule and rule amendments, do so by
February 1, 2006.142
C. HedgeFundRegulationAfter Goldstein
This section discusses the D.C. Circuit's decision in Goldstein to vacate
the Hedge Fund Rule, and how the SEC has responded to the court's
holding. Part I.C. 1sets forth the court's reasoning as to why it held that the
SEC had exceeded its authority when it tried to interpret the term "client" to
include the "shareholders, limited partners, members, or beneficiaries" of a
hedge fund.143 Part I.C.2 addresses the Commission's response in choosing
not to challenge the circuit court's decision and then sets forth the elements
of the new antifraud rule that the SEC promulgated in response to
Goldstein.
138. Id.at 125 (citing STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supranote 33, at
76-80).
139. SEC Release: Hedge Fund Rule, supranote 95, at 72,054.
140. Goldstein, 451 F.3d at 877 (citation omitted) (quoting 17 C.F.R. § 275.203(b)(3)-
1(d)(1)).
141. Id. (quoting 17 C.F.R. § 275.203(b)(3)-2(a)). The rule also
trigger[ed] certain regulations that apply only to registered advisers. Most
importantly, registered advisers [were required to] open their records to the
Commission upon request and [could] not charge their clients a performance fee
unless such clients [had] a net worth of at least $1.5 million or at least $750,000
under management with the adviser.
Id. at 877 n.3 (citing 15 U.S.C. §§ 80b-4, 80b-5 (2006)).
142. SEC Release: Hedge Fund Rule, supranote 95, at 72,054.
143. Goldstein,451 F.3d at 874 (quoting 17 C.F.R. § 275.203(b)(3)-2(a)).
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THE SEC'S NEWANTIFRA UD RULE
1. Goldstein v. SEC
In Goldstein, Philip Goldstein, Kimball & Winthrop, Inc. (an investment
advisory firm Goldstein co-owned), and Opportunity Partners L.P.
challenged the Hedge Fund Rule's equation of "client" with "investor." 144
Goldstein's main contention with the rule was "that the Commission's
action misinterpreted §203(b)(3) of the Advisers Act." 145
The court acknowledged that the Advisers Act does not define the term
"client," but rejected the SEC's argument that the lack of a definition
rendered the statute "ambiguous as to a method for counting clients."'146
Although "client" is not defined, the court found that legislative history and
the definition of "investment adviser" provided support for the view that
"Congress did not intend 'shareholders, limited partners, members, or
beneficiaries' of a hedge fund to be counted as 'clients."1 47 The court held
that the SEC's definition of "client" under the Hedge Fund Rule was
"outside the bounds of reasonableness"'148 and that it came close to
"violating the plain language of the statute." 149
The new rule was
overturned by the court, stating that "[a]bsent ...a justification" their new
interpretation of "client" seemed "completely arbitrary."']50
Although the court invalidated the rule, it noted that a later registration
requirement that is more narrowly tailored with regard to look-throughs
may be upheld.151 Also, if Congress were to amend the Advisers Act, it
"would effectively supersede Goldstein and expand the range of options
available to regulate this area." 152
144. Id.
145. Id. at 878.
146. Id. The court pointed out that just because a word is not defined, it does not
automatically render it ambiguous. Id.
147. See id. at 879. The court noted,
Although the statute does not define 'client,' it does define 'investment adviser' as
'any person who, for compensation, engages in the business of advising others,
either directly or through publications or writings, as to the value of securities or as
to the advisability of investing in, purchasing, or selling securities.'
Id. (quoting 15 U.S.C. § 80b-2(11) (2006)). The court found this definition indicates that an
investor is not a client because an adviser to a hedge fund does not advise an investor as to
how to handle his capital, but rather, the adviser provides advice to the fund itself as to how
to invest the capital it has collected from its investors. Id.at 879-80.
148. Id. at 879-81.
149. Id. at 881 ("At best it is counterintuitive to characterize the investors in a hedge fund
as the 'clients' of the adviser.").
150. Id. at 883.
151. See JW. Verret, Dr. Jones and the Raiders of Lost Capital: Hedge Fund
Regulation, PartI,A Self-Regulation Proposal,32 DEL. J. CORP. L. 799, 810 n.64 (2007)
(.'[T]he Commission has not justified treating all investors in hedge funds as clients for the
purpose of the rule. If there are certain characteristics present in some investor-adviser
relationships that mark a 'client' relationship, then the Commission should have identified
those characteristics and tailored its rule accordingly."' (quoting Goldstein, 451 F.3d at
883)).
152. Id. at 810.
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FORDHAMLAW REVIEW
After the Goldstein decision, SEC Chairman Christopher Cox told
Congress that the SEC would continue to bring enforcement actions against
hedge funds and hedge fund advisers that violate the antifraud and other
provisions of the securities laws. 153 During Chairman Cox's testimony, he
declared that "[h]edge funds are not, should not be, and will not be
unregulated."'154 With the importance that hedge funds have on the market,
it is inevitable that they will face "increased regulatory scrutiny which, after
Goldstein, will come largely in the form of enforcement actions and
investigations." 155
2. The New Antifraud Rule: The SEC's Response to Goldstein
In July 2007, the five SEC commissioners voted unanimously to adopt a
new antifraud rule under the Advisers Act that "prohibit[s] advisers to
pooled investment vehicles from defrauding investors or prospective
investors in pooled investment vehicles they advise."' 156 Rule 206(4)-8
(New Antifraud Rule) was promulgated in response to the Goldstein
decision. 157 The rule became effective on September 10, 2007, thirty days
after publication in the Federal Register. 158
The Commission felt that Goldstein created uncertainty with regard to
the application of sections 206(1) and (2) of the Advisers Act in relation to
investors who are defrauded by an investment adviser to that pool.159 Prior
to Goldstein, the SEC "brought enforcement actions against advisers
alleging false and misleading statements to investors under sections 206(1)
and 206(2) of the Advisers Act." 160 The court of appeals in Goldstein held
that, "for [the] purposes of sections 206(1) and (2) of the Advisers Act, the
'client' of an investment adviser managing a pool is the pool itself, not an
153. See Thomas 0. Gorman & William P. McGrath, Jr., What Every Issuer, Director
and Officer Should Know About CurrentSEC Enforcement Policiesand Trends, SEC. REG.
L.J., Summer 2007, at 1 (2007). When Chairman Cox testified before Congress, he made the
following statement:
[L]et me make very clear that notwithstanding the Goldstein decision, hedge funds
today remain subject to SEC regulations and enforcement under the antifraud, civil
liability, and other provisions of the federal securities laws. We will continue to
vigorously enforce the federal securities laws against hedge funds and hedge fund
advisers who violate those laws.
The Regulation of Hedge Funds: Before the S. Comm. on Banking, Housing and Urban
Affairs, 109th Cong. 3 (2006) (statement of Christopher Cox, Chairman, U.S. Securities and
Exchange Commission).
154. The Regulation of Hedge Funds: Before the S. Comm. on Banking, Housing and
Urban Affairs, 109th Cong. 3 (2006) (statement of Christopher Cox, Chairman, U.S.
Securities and Exchange Commission).
155. Gorman & McGrath, supranote 153, at 11.
156. 15 U.S.C. § 80b-6(4) (2006); SEC Release: Antifraud Rule, supra note 38, at
44,756.
157. SEC Release: Antifraud Rule, supra note 38, at 44,756.
158. Id.
159. Id. at 44,756-57.
160. Id. at 44,757 n.4 (citations omitted).
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THESEC'S NEWANTIFRA UD RULE
investor in the pool.' 16 1
The court "distinguished sections 206(1) and (2)
from section 206(4) of the Advisers Act, which is not limited to conduct
aimed at clients or prospective clients of investment advisers."'1 62 The
Commission found that this view made it unclear whether the Commission
could continue to bring enforcement actions under sections 206(1) and (2)
when investors are defrauded by an investment adviser to that pool. 163
The New Antifraud Rule was adopted pursuant to the authority granted to
the SEC in section 206(4) of the Advisers Act. 164 Under the Advisers Act,
the Commission has "broad authority to protect against fraud" by
investment advisers. 165 Section 206(4) of the Advisers Act provides that it
is unlawful for investment advisers "to engage in any act, practice, or
course of business which is fraudulent, deceptive, or manipulative," and it
instructs the Commission to adopt rules and regulations that "define, and
prescribe means reasonably designed to prevent, such acts, practices, and
courses of business as are fraudulent, deceptive, or manipulative" by
advisers. 166 Although Goldstein called into question the scope of sections
206(1) and 206(2), the Commission's authority to adopt rules under 206(4)
to protect investors in pooled investment vehicles was not questioned. 167
The authority granted under section 206(4) is "broader in scope and [is] not
limited to conduct aimed at clients or prospective clients."'168
The new rule seeks to enforce the authority of the Advisers Act
governing cases in which investors in a pool are defrauded by an adviser. 169
It has two parts: The first part, 206(4)-8(a)(1), specifically makes it
unlawful for an investment adviser to a pooled investment vehicle to make
any materially false or misleading statements to investors or prospective
investors. 170 The second part of the rule, 206(4)-8(a)(2), is purposefully
broader in prohibiting "other frauds."' 71
All investment advisers to pooled investment vehicles, regardless of
whether or not they are registered with the SEC, are subject to enforcement
of the new rule.172 Rule 206(4)-8 covers investment advisers with respect
to any "pooled investment vehicle" they advise. 173 A pooled investment
vehicle is defined as "any investment company defined in section 3(a) of
161. Id. at 44,756-57.
162. Id. at 44,757 (citing Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006)).
163. See id. at 44,756-57.
164. See id. at 44,757.
165. Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited
Investors in Certain Private Investment Vehicles; Proposed Rule, Investment Advisers Act
Release No. IA-2576, 72 Fed. Reg. 400, 401 (Jan. 4, 2007) [hereinafter Proposal Release:
Antifraud Rule].
166. 15 U.S.C. § 80b-6(4) (2006).
167. See Proposal Release: Antifraud Rule, supranote 165.
168. Id. at 401.
169. See SEC Release: Antifraud Rule, supranote 38, at 44,757.
170. Id. at 44,758.
171. Id. at 44,759.
172. See id.
173. Id.
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FORDHAMLAWREVIEW
the Investment Company Act and any privately offered pooled investment
vehicle that is excluded from the definition of investment conipany by
reason of either section 3(c)(1) or 3(c)(7) of the Investment Company
Act." 174 This definition results in the rule's applicability to "advisers to
hedge funds, private equity funds, venture capital funds, and other types of
privately offered pools that invest in securities, as well as advisers to
investment companies that are registered with [the Commission]." 175
a. ProhibitionofFalseorMisleadingStatements
Under the first part of New Antifraud Rule, it would constitute a
"fraudulent, deceptive, or manipulative act, practice or course of business
within the meaning of section 206(4)" if any investment adviser to a pooled
investment vehicle were to make
any untrue statement of a material fact or to omit to state a material fact
necessary to make the statements made, in the light of the circumstances
under which they were made, not misleading, to any investor or
prospective investor in the pooled investment vehicle. 176
The new rule prevents advisers from making false or misleading
statements to investors and prospective investors regardless of the context
in which those statements are made. This aspect of the rule differs from
rule 1Ob-5 under the Exchange Act, which is applicable only when the fraud
is committed in connection with the offering, selling, or redeeming of
securities. 177 The Commission provided some examples of what is
prohibited under this part of the rule:
materially false or misleading statements regarding investment strategies
the pooled investment vehicle will pursue, the experience and credentials
of the adviser (or its associated persons), the risks associated with an
investment in the pool, the performance of the pool or other funds advised
by the adviser, the valuation of the pool or investor accounts in it, and
practices the adviser follows in the operation of its advisory business such
as how the adviser allocates investment opportunities. 178
This part of the New Antifraud Rule is modeled after sections 206(1) and
206(2) of the Advisers Act, which make it unlawful for advisers to commit
fraud upon clients or prospective clients. 179 Accordingly, the rule applies to
174. Id. Under section 3(c)(1) of the Investment Company Act, issuers of securities
(other than short-term paper) ofwhich are beneficially owned by not more than 100 persons
and that is not making or proposing to make a public offering of its securities, are exempt
from regulation. Id. at 44,758 n.21. Section 3(c)(7) of the Act "excludes from the definition
of investment company an issuer the outstanding securities of which are owned exclusively
by persons who, at the time of acquisition of such securities, are 'qualified purchasers' and
that is not making or proposing to make a public offering of its securities." Id.
175. Id. at 44,758.
176. 17 C.F.R. § 275.206(4)-8(l)(1) (2008).
177. Proposal Release: Antifraud Rule, supranote 165, at 402.
178. SEC Release: Antifraud Rule, supranote 38, at 44,759.
179. Id.
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THE SEC'SNEW ANTIFRAUD RULE
communications not only with current investors in the fund, but also to
prospective investors. 180 Therefore, the rule covers, for example, false or
misleading statements to prospective investors in "private placement
memoranda, offering circulars, or responses to 'requests for proposals,'
electronic solicitations, and personal meetings arranged through capital
introduction services." 81
b. Prohibitionof OtherFrauds
The second part of rule 206(4)-8 is purposefully broad in order to
prohibit deceptive conduct that may not involve statements. 182 The rule
makes it "a fraudulent, deceptive, or manipulative act, practice, or course of
business" for an investment adviser to "[o]therwise engage in any act,
practice, or course of business that is fraudulent, deceptive, or manipulative
with respect to any investor or prospective investor in the pooled
investment vehicle."'1 83
In enforcing the rule, the SEC is not required to demonstrate that an
adviser has violated rule 206(4)-8 deliberately. Therefore, the rule covers
negligent conduct, as well as reckless or deliberately deceptive conduct. 184
The rule does not give rise to a private cause of action, so investors are not
able to use it to sue a manager, but the Commission will enforce it through
civil and administrative enforcement actions.185
D. The Role of Government andAlternatives to SECEnforcement
The continued growth of the hedge fund industry has attracted increased
attention and questioning as to whether there should be greater legal or
regulatory protections for investors in hedge funds.' 86 "Debate continues
among civil regulatory agencies and in Congress as to what, if anything,
should be done to regulate the industry to control potential fraud and
abuse."'187 Critics of regulation of the hedge fund industry argue that
overregulation could stifle the liquidity hedge funds bring to the securities
market.1 88 Others argue that hedge funds will move offshore to avoid the
180. Id. at 44,758-59.
181. Id. at 44,757-58.
182. Id. at 44,759.
183. 17 C.F.R. § 275.206(4)-8(a)(2) (2008).
184. See SEC Release: Antifraud Rule, supranote 38, at 44,759-60.
185. See id. at 44,757, 44,760.
186. Two major concerns with regard to hedge funds are whether their activities are a
threat to financial stability, and whether the current legal or regulatory protections
adequately protect hedge fund investors. This Note focuses only on the second concern.
187. Federal Bureau of Investigation, supra note 29.
188. Verret, supra note 151, at 825 (pointing to former Federal Reserve Chairman Alan
Greenspan as one such critic); see also NominationofAlan Greenspan: HearingBefore the
S. Comm. on Banking,Housing,andUrbanAffairs, 108th Cong. 25-26 (2004) (statement of
Alan Greenspan, Federal Reserve Chairman), available at http://frwebgate.access.gpo.
gov/cgi-bin/getdoc.cgi?dbname= 108_senatejhearings&docid=fi22918.pdf.
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regulation. 189 This section discusses alternatives to SEC regulation in
response to increasing interest and concern over the growth of the hedge
fund industry. Part I.D. 1 analyzes the response of the President's Working
Group on Financial Markets (PWG) and summarizes its February 2007
release of Principles and Guidelines for Private Pools of Capital. Part I.D.2
reviews the best practices for hedge fund participants that were written by
two industry groups established by the PWG and released in April 2008.
Part I.D.3 discusses recommendations promulgated by the Managed Funds
Association (MFA) in response to the PWG's February release. Finally,
Part I.D.4 explores the role of Self-Regulatory Organizations (SROs) in the
U.S. securities industry.
1. PWG Principles and Guidelines
The PWG is chaired by the Secretary of the Treasury and comprised of
the chairs of the Federal Reserve Board, the SEC, and the Commodity
Futures Trading Commission (CFTC). 190 The PWG was created by
President Ronald Reagan's executive order issued "on March 18, 1988 in
order to [enhance] the integrity, efficiency, orderliness, and competitiveness
of our Nation's financial markets and [maintain] investor confidence." 91
On February 22, 2007, the PWG released its Principles and Guidelines
Regarding Private Pools of Capital (PWG Principles). 192 The PWG
Principles were intended to "guide U.S. financial regulators as they address
public policy issues associated with the rapid growth of private pools of
capital, including hedge funds," while trying to preserve the benefits
provided by these funds. 193 The principles provide a framework for
189. Id. at 827; Douglas Cumming, A Law and Finance Analysis of Hedge Funds 3 (Apr.
5, 2008), availableat http://ssrn.com/abstract=946298.
190. U.S. Treasury, Office of Domestic Finance, http://www.treas.gov/offices/domestic-
finance/financial-markets/fin-market-policy/ (last visited Oct. 24, 2008). The President's
Working Group on Financial Markets (PWG) was originally formed to study the stock
market crash of 1987, and "since then has periodically issued reports on various issues
affecting the U.S. markets, including a 1999 report on hedge funds assessing lessons learned
in the wake of the near-collapse of Long Term Capital Management." Kathleen A. Scott,
President's Working Group Issues New Guidelines for US Hedge Funds, FIN. SERVS.
ADVISORY UPDATE (White & Case LLP, New York, N.Y.), Mar. 2007, at 3, 3, availableat
http://www.whitecase.com/files/FileControlcl 88a091-498f-43c5-95 11-930b45d47317/7483
b893-e478-44a4-8fed-f49aa917d8cf/Presentation/File/FSAU March_07.pdf.
191. INVESTORS' COMM., PRESIDENT'S WORKING GROUP ON FIN. MKTS, PRINCIPLES AND
BEST PRACTICES FOR HEDGE FUND INVESTORS 3 (2008) [hereinafter PWG BEST PRACTICES-
INVESTORS], available at http://www.amaicmte.org/Public/InvestorsCommitteeReport.pdf
(alterations in original) (internal quotation marks omitted).
192. PRESIDENT'S WORKING GROUP ON FIN. MKTS., AGREEMENT AMONG PWG AND U.S.
AGENCY PRINCIPALS ON PRINCIPLES AND GUIDELINES REGARDING PRIVATE POOLS OF CAPITAL
(2007) [hereinafter PWG PRINCIPLES AND GUIDELINES], available at http://www.treas.gov/
press/releases/reports/hp272_principles.pdf
193. Press Release, U.S. Dep't of the Treasury, President's Working Group Releases
Common Approach to Private Pools ofCapital: Guidance on Hedge Fund Issues Focuses on
Systemic Risk, Investor Protection (Feb. 22, 1007) [hereinafter PWG Release], availableat
http://www.treasury.gov/press/releases/hp272.htm.
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THE SEC'SNEW ANTIFRA UD RULE
addressing two key goals: "mitigating the potential for systemic risk in
financial markets and protecting investors."'194 The underlying philosophy
of the PWG Principles is "to encourage and improve transparency and
disclosure by pools and managers to counterparties, creditors, fiduciaries
and investors" while recognizing that "this transparency, disclosure and
supervisory vigilance should not discourage innovation."'1 95 These broad
principles are comprehensive but flexible in order "to endure as financial
markets continue to evolve" while providing a clear "principles-based
approach to address the issues presented by the growth and dynamism of
these investment vehicles."' 96
The preamble to the PWG Principles highlights, as the PWG noted in
1999, that "'[i]n our market-based economy, market discipline of risk-
taking is the rule and government regulation is the exception. "'197 The
report emphasizes as one of its "overarching principles" that "[p]rivate
pools of capital bring significant benefits to the financial markets," but
recognizes that they also "present challenges for market participants and
policymakers."' 198 The principles state that "[p]ublic policies that support
market discipline, participant awareness of risk, and prudent risk
management are the best means of protecting investors and limiting
systemic risk."' 199 They further provide that investor protection concerns
are most effectively addressed "through a combination of market discipline
and regulatory policies that limit direct investment in such pools to more
sophisticated investors. '200
The principles address private pools of capital and suggest that they
"maintain and enhance information, valuation, and risk management
systems to provide market participants with accurate, sufficient, and timely
information."20 1 Investors are encouraged to "consider the suitability of
investments in a private pool in light of investment objectives, risk
tolerances, and the principle of portfolio diversification. '202 In addition, the
PWG calls on regulators and supervisors to "work together to communicate
and use authority to ensure that supervisory expectations regarding
counterparty risk management practices and market integrity are met. '20 3
The PWG Principles accept and address the risk involved with
investment in these private pools of capital. Although many of the
strategies and vehicles used by these private pools of capital "are by their
194. Robert K. Steel, Under Sec'y for Domestic Fin., U.S. Dep't of the Treasury,
Remarks on Private Pools of Capital (Feb. 27, 2007) [hereinafter Steel on Private Pools on
Capital], availableat http://www.treasury.gov/press/releases/hp280.htm.
195. Id.
196. PWG Release, supranote 193.
197. PWG PRINCIPLES AND GUIDELINES, supranote 192, at 1 (quoting LESSONS OF LTCM,
supranote 43, at 26).
198. Id.
200. PWG PRINCIPLES AND GUIDELINES, supranote 192, at 1.
202. Id.
203. Id.
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FORDHAMLAW REVIEW
very nature potentially more opaque, illiquid, and complex than other
products," the option to invest in them is offered "only to certain approved
investors." 20 4 Therefore, when Under Secretary for Domestic Finance
Robert K. Steel discussed the PWG Principles, he stressed that investors
should "understand their investments and the corresponding risks and
should not expose themselves to intolerable risk levels."20 5 He also
addressed the "possibility of a retiree having his or her pension reduced or
eliminated as a result of losses from a poorly performing hedge fund
investment. '20 6 Steel admonished that managers should "disclose risks to
investors" and that "investors [should] assess and understand the risks
associated with their investments." 20 7 He also underscored that "[a]ll
investment fiduciaries have a duty to perform due diligence to ensure that
their investment decisions on behalf of their beneficiaries and clients are
prudent and conform to established sound practices consistent with their
responsibilities."
20 8
2. PWG Principles and Best Practices
In September 2007, the PWG established two "blue-ribbon private-sector
committees" to build upon the PWG Principles by collaborating on industry
issues and developing best practices for hedge fund investors and asset
managers. 20 9 In June 2007, U.S. Secretary of Treasury Henry Paulson
announced the PWG's plan to "call upon experienced industry participants
who could lead the charge to raise standards for improving transparency
and accountability. ' 210 Thereafter, the PWG selected Eric Mindich, CEO
of Eton Park Capital Management, as chairman of the Asset Managers'
Committee, and Russell Read, Chief Investment Officer of the California
Public Employees' Retirement System, to chair the Investors'
Committee.21 The Asset Managers' Committee (AMC) is comprised of
"representatives from a diverse group of hedge fund managers representing
many different investment strategies" and is "charged with developing best
practices specifically for managers of hedge funds."212 The Investors'
Committee is comprised of "senior representatives from major classes of
institutional investors including public and private pension funds,
foundations, endowments, organized labor, non-U.S. institutions, funds of
hedge funds, and the consulting community" and is "charged with
developing best practices specifically for those making hedge fund
204. Steel on Private Pools of Capital, supranote 194.
205. Id.
206. Id.
207. Id.
208. Id.
209. Press Release, U.S. Dep't of the Treasury, PWG Private-Sector Committees Release
Best Practices for Hedge Fund Participants (Apr. 15, 2008) [hereinafter PWG Best Practices
Release], availableat http://www.treasury.gov/press/releases/hp927.htm.
210. Id.
211. Id.
212. Id.; see also PWG BEST PRACTICES-INVESTORS, supranote 191, at 4.
[Vol. 77

investments." 213 The April 2008 press release about the resulting "separate
yet complimentary sets of best practices" heralded this to be "the most
comprehensive public-private effort to increase accountability for
participants in this industry. '214
Consistent with the PWG Principles, the Best Practices for Hedge Fund
Investors (Best Practices for Investors) cautions that investment in hedge
funds is only suitable for "sophisticated and prudent investors who are able
to identify, analyze and bear the associated risks, and follow appropriate
practices to evaluate, select, monitor, and exit these investments." 215 The
stated goal of the report, which is comprised of a "Fiduciary's Guide" and
an "Investor's Guide," is "to define a set of practice standards and
guidelines for fiduciaries and investors considering or already investing in
hedge funds on behalf of qualified individuals and institutions." 216
The Fiduciary's Guide, which is aimed at those with portfolio oversight
responsibilities, "provides recommendations to individuals charged with
evaluating the appropriateness of hedge funds as a component of an
investment portfolio."217 Fiduciaries are directed to "exercise proper care
in assessing whether a hedge fund program is appropriate and whether they
employ or can engage investment professionals with sufficient skill and
resources to initiate, monitor, and manage such a program successfully." 218
The Fiduciary's Guide then discusses hedge funds and outlines important
characteristics and issues that should be considered by a fiduciary when
deciding what percentage of a fiduciary's total portfolio should be allocated
to hedge funds.219 It then discusses minimum requirements for developing
"policies that define the key features and objectives of the hedge fund
investment program" and includes a list of questions that should be
addressed.220 The final issue addressed under the Fiduciary's Guide is the
213. PWG BEST PRACTICES-INVESTORS, supranote 191, at 4. The Investors' Committee
plans to "meet semiannually and issue clarifications and additions when appropriate." Id.
214. PWG Best Practices Release, supra note 209 ("The recommendations complement
each other by encouraging both types of market participants to hold the other more
accountable.").
215. PWG BEST PRACTICES-INVESTORS, supranote 191, at 1.
216. Id. at 2. The Investors' Committee is clear to point out that each individual or
institution considering or managing hedge fund allocations is different and therefore, each
much evaluate the best practices, "determine which apply, and implement the
recommendations that are reasonable given the resources available to the investor, its
objectives and risk tolerance, and the particular investments under consideration." Id. at 3.
217. Id. at 1.
218. Id. at 6. In order to assess the appropriateness of a hedge fund program, the
Investors Committee instructs a prudent fiduciary to address questions on the following
issues: "Temperament"; "Manager Selection"; "Portfolio Level Dynamics"; "Liquidity
Match"; "Conflicts of Interest"; "Fees"; and "Citizenship." Id. at 6-7.
219. Id. at 8-9. Some of the important features discussed include the typical fee structure
of hedge fund managers, whether hedge funds are newly formed, the experience or
sophistication of hedge fund managers. Id. at 9-12.
220. Id. at 12. The list of questions includes the following: "What is the strategic
purpose of investing in hedge funds?" "What role will hedge funds play in the total
investment portfolio?" "Is the hedge fund program consistent with the applicable investment
beliefs, objectives, and risk profile of the investment program?" "What are the performance
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FORDHAMLAW REVIEW
due diligence process, which is "the set of procedures used to gather
information about a particular investment for the purpose of deciding
whether the investment opportunity is appropriate." 221 A fiduciary is
instructed to "review the history of the investment management firm and its
professionals, the firm's past and current portfolios, its investment
philosophy, its decision processes for implementing the investment
strategy, its organizational culture, and its internal economic incentives" in
order to understand how a hedge fund may perform in different future
scenarios. In addition, "the due diligence process should also include an
evaluation of the business infrastructure, investment operations, and
controls in place to support the hedge fund's investment strategy. '222
Finally, it is important that a fiduciary continually monitor a manager and a
hedge fund investment because, "[w]hile the initial due diligence serves to
qualify a hedge fund as a desirable investment, the ongoing monitoring
process continually reaffirms that the assumptions used in the initial
selection remain valid. '223
The Investor's Guide describes best practices and guidelines for
investment professionals charged with "executing and administering a
hedge fund program once a . . . hedge fund [has been added] to the
investment portfolio." 224 This portion of the report provides
recommendations that "focus on how investors can apply appropriate due
diligence standards to verify that hedge fund managers are following best
practices and identify independent controls and processes to further
safeguard their assets."225 These recommendations are divided into seven
broad categories: "the due diligence process; risk management; legal and
and risk objectives of the hedge fund investment program?" "Who will manage the hedge
fund investment program and what responsibilities will they have?" "What investment
guidelines will apply to the range of funds and strategies that can be utilized, the number of
funds to be targeted, and the risk and return targets for those funds?" Id.
221. Id. Although due diligence is generally important for all investment activities, the
committee warns that
particular care should be exercised in due diligence of hedge funds, because of the
complex investment strategies they employ; the fact that hedge fund organizations
are frequently young and small; their use of leverage and the associated risks; the
possibilities of concentrated exposure to market and counterparty risks, and the
generally more lightly regulated nature of these organizations.
Id.
222. Id. at 13.
223. Id. at 14 ("Key aspects of the monitoring process should include reviewing the
investment strategy and investment performance for consistency, maintaining awareness of
factors that could indicate potential style drift, and confirming that there has been no
material change to the business operations of the fund manager.").
224. Id. at 1. The term "investor" is used narrowly in the Investor's Guide "to refer to the
internal and external personnel who are responsible for actually implementing and executing
these programs." Id. at 16.
225. Id. at 16. Where appropriate, the committee "specified certain procedures or
approaches that [it] believe[s] would add significant transparency and increase investors'
ability to understand and evaluate funds' risks and returns." Id.
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regulatory considerations; valuation; fees and expenses; reporting; and
taxation."
226
The due diligence process for investors begins prior to making an
investment and is continued while the investment is held. When deciding
whether to invest in a hedge fund, investors often use due diligence
questionnaires to gather information about managers, conduct meetings
with fund managers, and interview a fund's current investors and business
counterparties. 227 The committee recommends that "[i]nvestors should
check references, research the hedge fund's key service providers, verify
factual information using independent sources, and follow-up with the
fund's personnel if the investors have trouble locating data or discover
information that poses concerns." 228 Moreover, investors should "evaluate
the reputation, credit rating, regulatory history, and background of the
individuals and entities who will be involved in the management and
administration of the hedge fund's investments." 229 After the investment is
made, its long-term success requires "[o]ngoing monitoring of all the hedge
funds in a portfolio, and the management of those funds." 230
The next section of the Investor's Guide addresses risk management
through suggesting "best practices for establishing the investor's own risk
management framework and best practices for evaluating the risk
management framework employed by a hedge fund manager."'231 This is
important because "[e]ffective risk management practices help investors
protect their assets, manage their expectations in selecting hedge funds,
mitigate exposure to unanticipated risks, and support informed, disciplined
investment decisions." 232 This section discusses various categories of risk
that are important for a hedge fund investment program to address, such as
"investment risk, liquidity and leverage, market risk, operational risk,
business continuity, and conflicts of interest. '233 Best practices are
suggested in order to monitor and manage each of these risks.234
The Legal and Regulatory section of the Investor's Guide surveys the
laws applicable to hedge funds and what investors should be aware of,
226. Id. at 16-17.
227. Id. at 17. The report suggests questions that may be used for a due diligence
questionnaire, which the committee contends "should ask probing questions into the material
aspects of a hedge fund's business and operations." Id. This section also discusses investor
considerations and provides best practices with regard to personnel, the "strength of a hedge
fund manager's business model," the performance track record of the hedge fund, the fund's
"ability to maintain the investment style or styles upon which the investor originally
evaluated or selected it as part ofa hedge fund portfolio," and model use. Id. at 19-22.
228. Id. at 17.
229. Id.
230. Id. Also, it is noted that "once an applicable lock-up period expires, the decision
whether to redeem should be deliberate and scrutinized regularly for as long as the
investment remains outstanding." Id.
231. Id. at22.
232. Id.
233. Id.
234. See id. at 22, 24-37.
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FORDHAMLAW REVIEW
including, but not limited to, confirmation that the fund complies with these
laws, confirmation ofjurisdiction over the fund, and the elements relating to
a hedge fund's governing documents that "describe the legal and business
terms of an investment in that fund. '235 The Investor's Guide also
discusses what an investor should consider with regard to valuation, which
"is the key to deciding whether to make an investment and to calculate
returns from that investment over time."236 Guidance is provided on what a
valuation policy should include, how valuation is governed, and on
different valuation methodologies and controls.237 The report also provides
guidance on the fees and expenses of hedge fund managers, the quality of
reports and fund transparency, and taxation.238 The Investor's Guide
concludes by reinforcing that "hedge funds require in depth and continuous
oversight by their investors," and that it is the investor's responsibility "to
understand the essential risk and reward prospects of each hedge fund
investment.
'2 39
The Best Practices for the Hedge Fund Industry (Hedge Fund Industry
Report) recommends "innovative and far-reaching practices that exceed
existing industry-wide standards" that seek to increase accountability for
hedge fund managers and "[c]alls on hedge funds to adopt comprehensive
best practices in all aspects of their business including the critical areas of
disclosure, valuation of assets, risk management, business operations, and
compliance and conflicts of interest. '240 The AMC states their belief that
these recommendations raise "the bar for the industry by providing strong
and clear guidance to managers for strengthening their practices in ways
that investors demand and the markets require," but also provide "managers
with appropriate flexibility to continue to innovate and grow."241
The Hedge Fund Industry Report focuses on five key areas that "would
most effectively promote investor protection and reduce systematic risk,"
including disclosure, valuation, risk management, trading and business
operations and compliance, conflicts, and business practices. 242 The first
235. Id. at 39; see also id. at 37-43.
236. Id. at 43.
237. See id.at 43-48.
238. See id.at 49-57.
239. Id. at 57.
240. ASSET MANAGERS' COMM., PRESIDENT'S WORKING GROUP ON FIN. MKTS., BEST
PRACTICES FOR THE HEDGE FUND INDUSTRY, at i-ii(2008) [hereinafter PWG BEST
PRACTICES-INDUSTRY], available at http://www.amaicmte.org/Public/AMC-Report.pdf.
The Asset Managers' Committee (AMC) notes that the evolution of hedge funds has led to a
"greater need for them to develop and maintain robust infrastructure, controls and business
practices." Id. at ii. It also notes that sophisticated institutional investors "have demanded
that hedge funds demonstrate appropriate infrastructure and controls in managing their
activities." Id.
241. Id. at iii.
242. Id. The report establishes a framework for each of the five issues that
1) states the goal and essential elements of the framework; 2) outlines clear and
consistently applied policies and procedures that provide a structure to help ensure
better educated investors and better managed hedge funds implement the
framework; 3) incorporates a regular process for reviewing and updating the
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